APPLIED ECONOMICS FOR MANAGERS: SESSION 3

I. REVIEW: SUPPLY AND DEMAND IN ACTION

A. SUPPLY AND DEMAND DETERMINE EQUILIBRIUM PRICE
AND QUANTITY
1. MARKET PRICE TENDS TO GIVE GOOD SIGNALS IF:
a. COMPETITION
b. INFORMATION
c. NO EXTERNALITIES
2. MAXIMIZATION OF TOTAL SURPLUS: CONSUMER +
PRODUCER SURPLUS = EFFICIENCY
B. INFORMATION, PRICE, VALUE, AND COST

1. PRICE AS A SIGNAL TO COORDINATE THE

ACTIVITIVIES OF INVIDUAL CONSUMERS AND FIRMS
2. POSSIBLE DEFINITION OF AN ECONOMIST: “ONE WHO
KNOWS THE PRICE OF EVERYTHING AND THE VALUE OF
NOTHING” , E.G., DIAMONDS VS WATER
a. DEMAND CURVES AS A SCHEDULE OF VALUE AT
THE MARGIN
⇒ TOTAL VALUE IS AREA UNDER DEMAND CURVE
b. SUPPLY CURVES AS A SCHEDULE OF COST AT THE
MARGIN
⇒ TOTAL COST IS AREA UNDER SUPPLY CURVE
3. EFFICIENT EQUILIBRIUM:
a. MARGINAL VALUE = P = MARGINAL COST = MC
b. RESOLVING THE DIAMONDS/WATER PARADOX
II. MARKET DISTURBANCES
A. SHIFTS IN THE SUPPLY CURVE
1. MOVE ALONG THE DEMAND CURVE
a. FALL (RISE) IN SUPPLY RAISES (LOWERS) PRICE
b. FALL (RISE) IN SUPPLY LOWERS (RAISES) QUANTITY
2. EXAMPLE: AN OUTPUT TAX OR COST INCREASE
3. SUPPOSE SUPPLY IS: P = 10 + 0.5Q
a. PRICE NECESSARY TO GET 36 UNITS PRODUCED IS $28
b. TAX OF $10 PER UNIT PRODUCED—
i. PRODUCERS NOW REQUIRE $28 TO PRODUCE 36 UNITS
ii. $28 AS BEFORE PLUS $10 FOR TAX COLLECTOR
B. SHIFTS IN THE DEMAND CURVE
1. MOVE ALONG THE SUPPLY CURVE
a. RISE (FALL) IN DEMAND RAISES (LOWERS) PRICE
b. RISE (FALL) IN DEMAND LOWERS (RAISES) QUANTITY
2. EXAMPLE: A SALES TAX OR DEMAND DECREASE
3. SUPPOSE DEMAND IS: P = 100 – 2Q
a. AT PRICE = $28, Q = 36
b. TAX OF $10 PER UNIT BOUGHT
i. TO BUY 36 UNITS, CONSUMERS ONLY WILLING TO
PAY $18 TO PRODUCERS
ii. WILLING TO PAY $28 IN TOTAL—NEED $10 FOR TAX
III. ANALYZING THE MARKET RESPONSE TO SHOCKS
A. PRICE AND OUTPUT RESPONSES
1. PRICE RESPONSES LESS THAN FULL AMOUNT OF
SUPPLY OR DEMAND SHOCK
2. CONSIDER OUR EXAMPLE:
a. SUPPLY: P = 10 + 0.5Q
DEMAND: P = 100 – 2Q
EQUILIBRIUM: P = $28, Q = 36
b. IF SUPPLY CURVE SHIFTS TO: P = 20 + 0.5Q
DEMAND: P = 100 – 2Q
EQUILIBRIUM: P = $36, Q = 32
B. MEASURING THE RESPONSE OF SUPPLY/DEMAND
1. ELASTICITY OF DEMAND
a. RESPONSIVENESS OF DEMAND TO PRICE CHANGES
∆Q Q
b. ELASTICIY OF DEMAND: ε D = −
∆P P
c. ε D = – (P/Q) x (∆Q/∆P) = – (P/Q) x (1/DEMAND SLOPE)
d. ε D DIFFERENT AT DIFFERENT POINTS ON LINEAR
DEMAND CURVE
e. ε D = – (28/36) x (1/2) = 0.39 IN INITIAL EXAMPLE
2. ELASTICITY OF SUPPLY
a. RESPONSIVENESS OF SUPPLY TO PRICE CHANGES
∆Q Q
b. ELASTICIY OF SUPPLY: ηs = −
∆P P
c. ηs = (P/Q) x (∆Q/∆P) = (P/Q) x (1/SUPPLY SLOPE)
d. ηs DIFFERENT AT DIFFERENT POINTS ON LINEAR
SUPPLY CURVE
e. ηs = (28/36) x (2) = 1.56 IN OUR INITIAL EXAMPLE
SHIFTS IN THE SUPPLY CURVE MOVE PRICE AND QUANTITY IN
THE OPPOSITE DIRECTION

$/UNIT

S’

P*’ S

P*

Q*’ Q*

DETAIL NEAR EQUILIBRIUM

S’
$/UNIT
AMOUNT OF
TAX OR COST
INCREASE
AMOUNT OF
S
PRICE RISE

Q
LESSON: FULL AMOUNT OF TAX OR COST INCREASE IS NOT
PASSED ON IN PRICE RISE
SHIFTS IN THE DEMAND CURVE MOVE PRICE AND QUANTITY
IN THE SAME DIRECTION

$/UNIT S

P*
P*’

D
D’

Q*’ Q*

DETAIL NEAR EQUILIBRIUM

$/UNIT
S

AMOUNT OF
TAX OR SHOCK
TO DEMAND

AMOUNT OF
D
PRICE DECLINE
D’
Q
LESSON: FULL AMOUNT OF TAX OR DEMAND SHOCK IS NOT
PASSED ON IN PRICE DECLINE
ELASTICITY VS SLOPE: THE PRICE OF BANANAS

$/UNIT DEMAND WHEN 1 BUNCH = 1 UNIT

$12

DEMAND WHEN 1 BANANA = 1 UNIT

$2

$12 72 Q
CONSIDER A SMALL VILLAGE IN THE FRENCH COUNTRYSIDE.
SUPPOSE WE DEFINE ONE UNIT OF BANANAS TO BE A BUNCH
OF 6 BANANAS. SUPPOSE FURTHER THAT AT A PRICE OF $12
PER BUNCH, VILLAGE DEMAND FOR BANANAS IS ZERO UNITS
(ZERO BUNCHES) WHILE AT A PRICE OF $0 PER BUNCH, TOTAL
DEMAND IS 12 UNITS (72 BANANAS). THEN VILLAGE BANANA
DEMAND IS GIVEN BY THE EQUATION:

P = 12 - Q, I.E., THE DEMAND SLOPE IS – 1

NOW SUPPOSE THAT WE DEFINE ONE BANANA UNIT AS JUST
ONE BANANA. THE DEMAND CURVE JUST DEFINED SAYS
THAT WHEN THE PRICE PER BANANA IS $2 (OR $12 PER 6),
DEMAND IS 0, WHILE DEMAND IS 72 BANANAS AT P = 0. THUS,
WHEN WE DEFINE A BANANA UNIT AS 1 BANANA, THE
VILLAGE DEMAND CURVE IS GIVEN BY:

⎛1⎞ 1
P = 2 - ⎜ ⎟ Q, I.E., THE DEMAND SLOPE IS −
⎝ 36 ⎠ 36